Periodic Cost Methods of Determining the Cost of Ending Inventory and Cost of Goods Sold

All expenditures needed to acquire goods and to make them ready for sale are included as inventorial cost.

It appears from the diagram that cost of goods available for sale = cost of beginning inventory + cost of goods purchased and cost of goods sold = cost of goods available for sale – ending inventory.

But in practice, goods are purchased several times at different prices for a particular period and same is the case with sales. In such situation, determination of cost of ending inventory becomes very difficult.

The cost of ending inventory and the cost of goods sold are determined using various methods of them, the commonly used methods are:

  1. First in first out (FIFO),
  2. Last in first out (LIFO), and
  3. Weighted average.

They are described below with example; first let’s look at the information given on the following table;

DateExplanationsUnitsUnit Cost
($)
Total cost
($)
Jan 1, 2013Beginning inventory200204,000
April 15, 2013Purchases400228,800
Aug. 8, 2013Purchases6002414,400
Nov. 27, 2013Purchases8002620,800
 *Ending Inventory on Dec-31-2013 was 900 units.TOTAL:200048.000

Now see the definitions and see what the cost of ending inventory in each method is;

1. First in first out (FIFO)

Under the first-in-first out method, the earliest costs (first costs) are assigned to cost of goods sold and the remaining costs (the more recent costs) are assigned to ending inventory.

The FIFO method assumes that the earliest-goods purchased are sold first. But in practice it is not followed strictly i.e. the earliest goods are sold first.

Let’s see the solution of our problem table-I under FIFO method;

DateUnitsUnit costTotal cost ($)
27-nov8002620,800
8-Aug100242,400
900Cost of Ending inventory23,200

The cost of ending inventory is $23,200 and the cost of goods sell is (48000-23200) $24,800.
Features of FIFO are;

  • In calculation of costs of Ending inventory; The more recent unit costs are assigned to the units not sold – those in ending inventory.
  • In calculation of Cost of goods sold; earliest unit costs are assigned to units sold – those in cost of goods sold expense.
  • Advantages
  • Simple to use.
    • Yields ending inventory amount on the balance sheet comprising more current costs than if weighted average or LIFO is used.
    • Usually produces cost flow that approximates physical flow better than does weighted average or LIFO.
  • Disadvantages
    • Does not match recent costs with current revenue as well as LIFO does.
    • Yields a higher taxable income than LIFO or weighted average during periods of rising prices.

2. Last in first out (LIFO)

The last in first out method (LIFO) is the reverse of the FIFO method. Under LIFO method the earliest costs are assigned to ending inventory and the costs of most recent purchases are assigned to the cost of goods sold.

The LIFO method assumes that the latest goods purchased are to be sold at first.

Let’s see the solution of our problem table-I under LIFO method;

DateUnitsUnit costTotal cost
$$
August 8300247,200
April 15400228,800
Jan. 1200204,000
Cost of ending inventory20.000

So the cost of goods sold is $28,000 (48000-2000).
Features of LIFO method;

  • In calculation of costs of ending inventory; the earliest unit costs are assigned to the units no sold – those in ending inventory.
  • In calculation of Cost of goods sold; the more recent unit costs are assigned to the units sold – those in cost of goods sold expense.
  • Advantages
    • Matches more recent costs with current revenue better than FIFO or weighted average.
    • Yields the lowest income, thus the lowest income tax obligation during periods of rising prices.
  • Disadvantages
    • Does not produce an ending inventory amount that contains costs as recent as those included under FIFO or weighted average.
    • The process is much complicated

3. Weighted average Method

The weighted average method is suitably applicable to that firm which deals with goods of equal importance. According to the weighted average method each unit of inventory of a particular type is similar and can be sold for the same price.

Units of equal economic importance are assigned equal costs. The weighted average method differing from LIFO or FIFO assigns an equal cost to each unit whether sold or unsold.

Under this method, unit cost is taken to be the weighted average cost of all goods ready for sale during a particular period.

The weighted average cost per units is applied in calculating the cost of closing or ending inventory, as well as the cost of goods sold.

Weighted average cost per unit of goods available= Total Cost of All Units available for Sale/ Total Units Available for sale.

So, according to our information; $48,000/2000units=$24.
The cost of ending inventory: 900 X $24 = $21,600.
And the cost of goods sold is $26,400(48000-21600).
Features of Weighted average Method;

  • In calculation of costs of Ending inventory; the same unit costs – the weighted average cost per unit – are assigned to units not sold and to units sold.
  • In calculation of Cost of goods sold; the same unit costs – the weighted average cost per unit – are assigned to units sold and unsold.
  • Advantages
    • Assigns equal unit cost to each unit of inventory.
    • Does not produce widely fluctuating profits when inventory costs are fluctuating, as FIFO and LIFO do.
  • Disadvantages
    • Does not match recent costs with current revenue as well as LIFO does.
    • Does not produce an ending inventory amount that contains costs as recent as those included under.